The Trouble with Predicting Investment Returns

The Trouble with Predicting Investment Returns

In a recent conversation with a new client’s long-term accountant, I was told – “I am very high on the Australian Stock market, but this is not the time for our client to invest. It’s best to wait and invest later”.

The idea that we can predict how investment markets behave is very alluring. But it’s important to recognise that the two largest market events in the past 15 years – the Global Financial Crisis (-50% over 2.5 years, recovery in 6 years) and the Covid Crisis (-30% over 2 months, recovery in 1 year) produced very different outcomes for investors and were each impossible to predict.

So, after 15 years managing clients’ wealth, I have learnt, Prediction is Futile. Preparation is Key.

The Problem with Predicting

Nobel Prize winning author Daniel Kahneman writes in Thinking, Fast and Slow that people experience numerous biases that lead them to over-estimate their predictive abilities.

Availability Bias

One source of bias is “availability bias”. This refers to our tendency to take into account the information that is available and accessible instead of what is relevant when making predictions. For example, an investor may overvalue a recent news report without fully appreciating that the media is “biased toward novelty and poignancy”. That is, even though market falls are less probable, they are reported more frequently than market gains. Accordingly, the threat of a fall may dominate investors’ behaviour.

Ignoring ‘Base Rates’.

Often, people will completely ignore statistical realities when these should instead form the foundation of any prediction. The Australian stock market has produced returns of 9.8% p.a. over the past 25 years, despite producing negative returns in 7 of those 25 years. Instead of letting these expectations govern future activities, investors often make “intuitive assessments” of future investment returns.

By tempering these tendencies, we can ensure our predictions are unbiased and therefore, more comfortably relied upon.

How to Prepare

Instead of making bold predictions that are worth no more than a “hunch”, there are many things we can all do to become better investors.

1. Establish Investment Infrastructure.

Having an investment or dedicated savings account allows you to develop good savings habits. So, when a cash injection such an asset sale, a bonus or tax return is received, having an investment account makes it easy to invest. Without the right tools, we can default to other behaviours such as spending more.

2. Expect Volatility.

Understanding that investment volatility is a normal part of the investment cycle allows us to use volatility to your advantage. One way to do this is to invest progressively. In periods when the share market falls, investing your hard-earned cash becomes easier when you appreciate that “shares are on sale” (as one client put it to me). Oh, and above all – don’t panic and sell!

3. Set Ambitious Goals.

In the absence of clear and measurable objectives, the “why” of investing may be missing. Positive savings habits should be linked to goals that achieve a purpose. For some, this may mean a holiday, a healthy retirement or charitable giving. What is your reason for investing?

4. Rely on the Right Data and Interpret Wisely.

Investors in the Yarra Lane Wealth Strategic Series Portfolios will appreciate that we do not make bold, intuitive predictions. Instead, we (along with our asset consultants) observe almost 400 data points and model various investment outcomes and the likelihood of each playing out. Doing so allows us to construct portfolios that are designed to capture the opportunities and manage the risks inherent in a range of possible futures.

As the saying goes, the best time to plant a tree was twenty years ago … the second-best time is now.

Rather than try to predict investment market returns we work closely with our clients to prepare them for a lifetime of investing. If you feel you are ready to start, your Yarra Lane Wealth advisers will share this journey with you.

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